Simple Econ

CFA Level II Economics
#1

Hi guys,

Can you take a few seconds to help me understand something Econ wise…

Question

One yr Australian deposit rate = 5.0%

One yr Japanese deposit rate = 1.0%

JPY/AUD spot rate = 79.25

Based on uncovered interest rate parity, over the next year, the expected change in the JPY/AUD will be closet to

A - decrease of 10%

B - decrease of 4%

C - increase of 4%

Answer = B, The expected depreciation of the australian dollar (decline in JPY/AUD rate) is equal to interest rate differential btwn Australia and Japan (5% - 1%)…

I selected answer C, wouldn’t it take more JPY to buy AUD and hence the exchange rate will increase??? Any feedback will be greatly appreciated…

#2

No: it will take 5% more AUD to buy 1% more JPY.

#3

Ok I know I should know this and I feel stupid asking but want to understand the reason behind this, isn’t an exchange rate the price of the base currency in terms of the price currency? (79.25 JPY to buy / 1 AUD). If AUD has higher interest rate, wouldn’t it cost more JPY to get 1 AUD?

#4

I believe S2000 is correct.

What part of the problem don’t you get?

The way I see it, there are two underlying points of logic in this problem; 1) why the AUD depreciates relative to the JPY in 1 year, and 2) why it will take less JPY (not more) to buy AUD in one year after the aforementioned depreciation.

  1. The AUD depreciates because (in the context of uncovered interest rate parity) if the AUD didn’t depreciate relative to the JPY in one year, all JPY investors would convert their currency to AUDs today and earn 5% (as opposed to the 1%), and subsequently convert the AUDs back into JPY in one year (or some other later date).

  2. If the AUD depreciates relative to the JPY, then it will take less JPY to purchase 1 AUD in the future. If the current spot rate is 79.25 JPY/AUD, then it takes 79.25 JPY to purchase 1 AUD. If the JPY appreciates relative to the AUD in 1 year, then it will take LESS JPY to purchase 1 AUD at the end of the year. Therefore, the JPY/AUD rate will decrease.

#5

No.

If the risk-free rate on JPY is 1% and the risk-free rate on AUD is 5%, then one year from today (assuming IRP holds):

  • It will cost 5% more AUD to buy 1% more JPY
  • It will cost 1% more JPY to buy 5% more AUD

Either way you slice it, JPY has appreciated (by about 4%) vis-à-vis AUD, and AUD has depreciated (by about 4%) vis-à-vis JPY.

#6

That is a great help, thank you both for taking the time to help, really, really apreciate it…

#7

My pleasure.

#8

Another way to look at the problem is using money market equilibrium. This means that the Exchange rate JPY/AUD level in Australia is resulted from relative scarcity of AUD and JPY in Australia.

If the AUD interest rate is higher than the JPY interest rate, the japannese investors will want to buy AUD to invest them at 5%, so the quantity of AUD available in Australian market has risen. What happen when a good is more abundant than before? Its price reduces, depreciales. JPY/AUD = 79.25 is the price of AUD in terms of JPY, so the exchange rate must decline. To be more clear, if JPY/AUD is 78.00 now, it means that lesser quantity of JPY is necessary to buy the same 1 AUD than before, the JPY has appreciated and the AUD has depreciated.

Also remember that _ uncovered interest rate parity holds when the differential of interest rates is offseted by the currency depreciation of the higher interest rate country _. In this case the higher interest rate is from Australia, and the exchange rate is nominated JPY/AUD, so AUD depreciates, this means that ER decrease by 4%.

Regards